Taxation and the distorted allocation of talent

That is a paper from last year by Benjamin B. Lockood, Charles G. Nathanson, and E. Glen Weyl. The key sentence of the abstract is this:

If higher-paying professions (e.g. finance and management) generate less positive net externalities than lower-paying professions (e.g. public service and education) taxation may enhance efficiency.

In other words, marginal tax rates may be Pigouvian taxes on externality-generating activities. Note that in this model high elasticities of switching careers, in response to incentives, may motivate progressive taxation rather than militating against it.

The paper does not attempt to derive which are the positive-externality and negative-externality professions, but rather considers some left- and right-wing assumptions about various professions, as well as the views of the authors.

If we consider wage structures within firms, equity norms and stickiness theories predict an excess of wage compression relative to marginal products. This is what we observe in academia and also scientific research. High marginal tax rates worsen that problem rather than alleviate it.

Most of all, I think of “fundamental innovation” as the great under-rewarded input. That doesn’t correspond well to either income levels or descriptions of professions, so maybe those are not the categories this paper should focus upon. And the number of true innovators may be fairly small, so thinking about typical cases may prove misleading. If we consult “our feelings” about various professions, we will focus on typical members of that profession and their social contributions, or lack thereof. An alternative approach is to start by listing the known under-rewarded innovators from the past, noting their distribution in the professions, and then thinking how to reward those professions with the tax system, along the way worrying less about the averages or typical members of those professions. That path will bring you some very different results, and I think results more favorable to both business and scientific research.

>The paper does not attempt to derive which are the positive-externality and negative-externality professions

Of course it doesn’t.

ClaudiaApril 5, 2014 at 7:17 am

No they don’t derive estimates but there is no shame in starting with the existing literature (they pull a lot of high quality sources) and also exploring some ranges to test their theory. From the paper:

“To calibrate externalities, we adopt two approaches. First, we present estimates of profession-specific externalities from the economics literature. Second, we include two sets of externality assumptions intended to reflect the poles of contemporary debates over income tax progressivity in the United States: the Tea Party and the Occupy Wall Street movement, both to show the sensitivity of the optimal tax schedule to a range of externality assumptions, and to demonstrate the usefulness of this model in formalizing observed political debates.”

See also page 15-20 in the paper for more details.

PS is a “true innovator” the flip side with a “ZMP worker” … what is up with all these type labels?

BCApril 5, 2014 at 11:53 am

I am puzzled by some of the externality measurements that the authors drew from the economics literature. For example, if one believes that externality effects are causing mis-allocation of talent from academia/science into finance, then one must believe that finance professionals in general would make better scientists than current scientists. Otherwise, where is the mis-allocation of talent? Of course, this is not a sufficient condition for an externality to exist — it’s possible that finance attracts the best otherwise-would-be-scientists for economically efficient reasons — but it’s a necessary condition. Yet, none of the measurements discussed seem to make any attempt to show that the presumed negative-externality professions are indeed attracting the most talented individuals that likely would have outperformed current positive-externality professionals in their current professions. For example, the authors don’t seem to have presented or cited any evidence that current salespeople (assumed zero-externality) would be much better teachers than current teachers (assumed positive externality).

My own personal observation as someone with an engineering PhD is that many of my talented peers enter both academia and finance. I would not assume that those entering finance are on average the more talented academic researchers although, again, that would seem to be a necessary condition for the authors’ findings. That’s why I’m so puzzled that they don’t seem to present evidence that this necessary condition is satisfied.

BCApril 5, 2014 at 12:01 pm

Actually, the description of teaching externality does appear to suggest that it measures teaching performance of “talented” students in some way, but it’s hard to tell from the one paragraph description (p. 19). I’m not interested enough to hunt down the references, but maybe the authors are in fact asserting that current teachers don’t teach as well as salespeople and CEOs would.

ClaudiaApril 5, 2014 at 12:20 pm

I believe the idea is if you have an industry with a negative externality, let’s say finance in which the chance of destroying value is NOT reflected in the wages of workers (i.e., private value > social value) then you are going to get too many people in finance instead of science. The market mechanism cannot efficiently allocate resources when prices do not reflect social value. You simply get too many people in the negative externality sectors because the taxpayers or investors are covering the downside of those jobs. The marginal finance worker does not have to be a better scientist … simply the world is better off (once all the externalities are internalized) with him being a scientist. All that said, I agree figuring out where the externalities truly are is tough and taxes may not be the best way to internalize the externalities. (A lot of the choices about which industry to work in go well beyond wages.)

RahulApril 5, 2014 at 1:30 pm

What about the other option? Paying scientists more?

BCApril 5, 2014 at 12:42 pm

Ok, after re-reading the finance externality description, I am even more confused. The authors consider private resources expended to “beat the market” through active management. The resources expended are private, as are the benefits, so no externality there. The externality generated by active managers, if any, would seem to be measured by the extent to which passive investors can obtain similar returns without themselves hiring managers and analysts or doing any investment research, i.e., the extent to which passive investors can free-ride on active managers’ price discovery activities. So, the value of this externality would seem to be something like the total value of assets invested passively times the difference between active fees and passive fees. That’s what passive investors save as a result of active managers’ activities, which active managers are unable to recover, i.e., externality. Yet, somehow, the authors came up with a negative number. Very confusing.

ClaudiaApril 5, 2014 at 12:53 pm

Here’s the text you were looking at right?

“Finance: French (2008) estimates the cost of resources expended to “beat the market” and Bai et al. (2013) argue that the dramatic increase in such expenditures has not made markets more informationally efficient. Viewing all of this waste as a negative externality of our talented individuals yields an externality share of −.6. A very similar estimate is obtained by assuming that all of the increase in the financial sector’s share of GDP (Philippon, 2013) from its trough mid-century is waste.”

So the Bai et al papers argues the costs of active trading do not improve market efficiency (which includes price discovery) so they use active trading costs to estimate the negative externality. Yes active trading makes some people rich – private value – but they argue that it is not of benefit to the market – social value. It is the mismatch of private / social net benefits that is an externality. I am probably not clearing this up any … it is tricky and one could easily disagree with these estimates.

BCApril 5, 2014 at 1:46 pm

Yes, that’s the section I was reading. The sense in which Bai et al say there is no improvement in market efficiency is that there is no improvement in ability of stock and bond prices to forecast earnings. So, that’s an argument against the increase of that particular positive externality (improved capital allocation). That does not imply that the private, internalized costs of active management represent a negative externality. A negative externality would arise when active investors obtain some sort of benefit paid for by passive investors. The costs estimated in the French paper are all *privately* borne costs (fees, transactions costs, etc.).

Also, if we believed that such a negative externality existed, then that would imply that there was a benefit to active investors, a benefit paid for by passive investors, but a benefit nonetheless. As far as I know, the consensus among most academics is that there is very little benefit to active investing. If active investors are not receiving a benefit, then they can’t be receiving a subsidized benefit.

To argue against the positive externality that I mentioned — the ability of passive investors to free-ride on active investors — one would need to argue that active investors actually do significantly outperform passive investors so that active investors actually do internalize most of the benefit of their activity.

Yes, those were both good pieces, especially the one from Streetwise Professor.

Jed HarrisApril 6, 2014 at 4:08 pm

BC and Claudia agree on the passage and content but not I think on whether the private value capture by active financial managers is a “negative externality”.

Perhaps an analogy with smoking can help. Leaving aside second hand smoke, smoking imposes arguably excessive costs relative to benefits on smokers even though it is a personal choice of the smoker. (Often smokers wish they did not smoke.) Some of that cost is captured as value by tobacco companies. We impose Pigovian taxes on tobacco, raising the costs to smokers and reducing smoking, leading to a net reduction in revenue to tobacco companies, and possibly a net reduction in costs to potential smokers.

Part of the issue here is that tobacco companies use part of their revenue to market tobacco, increasing the number of smokers and thus the costs smoking imposes. We regulate tobacco advertising but arguably more / higher Pigovian taxes would be more efficient.

The same pattern applies to active investment management — it imposes costs on customers, gets some of those costs as revenues, uses some of those revenues for marketing. Lockwood et al cite sources who argue that these costs do not generate individual or social value, so they are a net loss to the customer. If the customer did not incur these costs they could invest or spend their money in ways that had more positive private and social value.

Whether or not we call these imposed costs an externality, Pigovian taxes could improve efficiency (granting that the costs of active investment management don’t generate commensurate value).

byomtovApril 6, 2014 at 11:01 am

if one believes that externality effects are causing mis-allocation of talent from academia/science into finance, then one must believe that finance professionals in general would make better scientists than current scientists.

I don’t think that’s right. They only have to more productive in science than they are in finance.

dan1111April 5, 2014 at 7:29 am

“An alternative approach is to start by listing the known under-rewarded innovators from the past, noting their distribution in the professions, and then thinking how to reward those professions with the tax system, along the way worrying less about the averages or typical members of those professions.”

This is a very interesting idea, but I am worried that it is built on assumptions that aren’t really true. Imagine a couple of alternative scenarios:

1) There are a fixed number of innovators in the population who are highly talented and are going to innovate no matter where they end up. Therefore, by favoring the sector with the most past innovation, you won’t increase the overall amount of innovation; you’ll just concentrate even more innovation in that one field, at the expense of others. This might reduce the total innovation, because innovation often has a decreasing return as a field of study matures.

2) Innovators are already drawn to certain fields (such as science) because those professions fit their skills and motivations. Because they are top-level talent, they can succeed in those fields even when there are fairly strong disincentives for entering them. Thus, favoring those fields will not increase the innovation much; instead, it will just increase the number of mediocre people that can enter the field. In this scenario, measuring the average productivity of a profession really is the best way to set policy.

I’m not saying either one of those is fully true, but there is at least some truth to both, in my opinion.

JFAApril 5, 2014 at 10:35 am

Your scenarios have the hidden assumption that people don’t respond to incentives. Color me dubious.

GiTApril 5, 2014 at 2:03 pm

No, it has the hidden assumption that some people are relatively or nearly absolutely insensitive to pecuniary incentives in particular contexts. Your hidden assumption appears to be that everyone responds to pecuniary incentives in all contexts.

JFAApril 5, 2014 at 3:17 pm

I would say that is my explicit assumption. Get a measure of innovation in an industry and a measure of compensation in that industry, and I doubt you find a low, positive correlation. That’s why we have had incredible erectile dysfunction drugs and not so many good malaria drugs. Innovation correlates with compensation

dan1111April 6, 2014 at 2:24 am

Of course there is a correlation, but that doesn’t mean it is the most important factor in this case. Tyler’s post is built on the premise that these top innovators are outliers, and I am arguing that their status as outliers may mean that their response to incentives isn’t so straightforward.

In my view, the top innovators are often highly motivated, driven people who will succeed even in a difficult environment. For an example, think of Einstein, who was not able to get a job in academia but still published ground-breaking research while working at the patent office. Of course there is a certain baseline level of opportunity needed–a highly talented person growing up in North Korea or Sudan is unlikely to be able to accomplish much–but once that baseline level is met, increasing incentives might not make a big difference.

Furthermore, innovators may be less motivated by monetary incentives than others. I feel that they are often driven by discovering new things, making a difference, and making things work better as ends in themselves–and perhaps the fame and prestige that come with these things. This is often necessary for bringing innovation, because it can be a less safe path than simply using one’s skills to make lots of money. This is somewhat speculative, but it is clear that many top people in the sciences choose a less lucrative path by entering academic research rather than industry.

Of course there is some response to monetary incentives in this as in any group. But if that response is relatively small, while the response of others in the same fields is much higher, then changing tax structure to encourage innovation would not be well targeted. It could even be harmful if there is a lot of inefficiency in the lower tiers of those fields.

prior_approvalApril 5, 2014 at 8:49 am

‘If we believe that investment has higher positive externalities over time than consumption…’

As has been demonstrably true for over a generation, Americans in aggregate clearly do not believe this.

‘…that militates in favor of leaving resources in the hands of wealthier individuals.’

Best satire site on the web. Expecially considering how a post referencing the behavior of rent seekers immediately follows this one.

Alexei SadeskiApril 6, 2014 at 7:16 am

1. Don’t have to be wealthy to be a successful rent seeker.

2. We can reductio ad absurdum what Americans believe pretty easy.

DogmaiApril 5, 2014 at 9:06 am

Having not read the paper, why is it assumed that “externalities” are the proper measure of efficiency? In the real world, people do not make economic calculations based on social utility functions, they make them based on agent specific considerations.

If it’s true that some academic economist were confident enough in their models to accurately measure an instance of underutilized talent then that, by definition, represents a profit opportunity, not an excuse to correct some cosmic wrong by progressive taxation.

Indeed, the very fact that those agents have chosen to allocate their talents profitably in the way that they have is wholly sufficient to determine that their actions are efficient.

Some professions create demand for other professions. Take “public service” which is just a form of parasitism. These spongers fill their day creating rules for the host. The host then creates jobs for people trained to navigate the rules created by the parasites.

RahulApril 5, 2014 at 10:26 am

Do cops perform a public service? How about firefighters? Or the crew that comes with a Vacator when shit backs up in your street sewer?

That Public services may be over-provided in the status quo is a perfectly reasonable opinion.

OTOH, labeling all public services as parasites is not.

JFAApril 5, 2014 at 11:08 am

That depends if public services are increasingly over-provided. If that is the case, public services take an increasing amount of resources away from other possible uses (just like a parasite would). I do not think this is the case for all public services, but I do not think it would be hard to imagine one or two examples (fire-fighters and K12 education are, I think, pretty good examples) for which the term parasitic is not entirely inapt.

AidanApril 5, 2014 at 9:58 am

Fundamental innovation is improtant: we certainly seem to be better off with flush toilets and penecillin than we were before they were invented. That said, I would be tempted to give the prevision of care the award for “the great under-rewarded input” in our society. Care work has historically been carried out mainly by women, been poorly paid and been regarded as low status. The kind of work carried out by carers – e.g. being available to comfort an elderly person \ baby \ injured person at 3 o’clock in the morning – brings huge benefits in terms of human wellbeing and is largely immune to technological innovation and displacement. It seems like the kind of thing we should be trying to encourage with the tax code.

Bob KnausApril 5, 2014 at 12:29 pm

The US already does, since household members provide most care. Its tax code privileges marriage and offers deductions for dependents.

A jonesApril 6, 2014 at 3:12 am

Do we have credible evidence that rewarding fundamental innovation creates more of it?

If we believe that investment has higher positive externalities over time than consumption, that militates in favor of leaving resources in the hands of wealthier individuals.

Indeed. Or we could try the more direct route: if he doesn’t exist he cannot consume.

Turkey VultureApril 5, 2014 at 11:30 am

If you want to differentially disfavor specific activities, tax them or change the rules to essentially tax them. If the legal sector produces a lot of negative externalities because there are too many lawsuits, charge higher filing fees. Any general attempt to change tax rates between industries based on perceptions of usefulness seems just as likely to reduce as to increase innovation. It requires too much faith in the broad wisdom of technocrats

EricApril 5, 2014 at 11:36 am

So we have made the assumption that markets are wholly inadequate to incentivize innovation?

Thing is it is not just the level of taxes but the expected level of future taxes. When taxes are low, as now, they can be expected to be higher in the future. When high, they can be expected to be lower in the future. These expectations are more important then their current level.

mulpApril 5, 2014 at 6:00 pm

“An alternative approach is to start by listing the known under-rewarded innovators from the past, noting their distribution in the professions, and then thinking how to reward those professions with the tax system,”

Ok, a few hundred people played key roles as employees working for the public on the Internet, paid for by taxes.

The argument since circa 1980 is that those people were under-rewarded innovators, so the tax system was changed, along with lots of laws and regulations in order to produce greater innovation.

One regulation was the prohibition of the Internet competing with the now highly incentivized innovators – commercial use of the Internet was prohibited, and the GAO was instructed that it set up bids to promote purchasing of commercial off the shelf products and services – the Internet was excluded. Obviously, agencies needed to be allowed to buy something if no COTS product existed, so lots of custom and proprietary single source products were granted waivers. The only thing that was near standard and available from multiple vendors was Internet products. Until circa 1990 when the competition for GAO contracts resulted in global industry standards under ISO, the OSI standard networking, developed by big corporations, drawing on the innovation the produced the Internet, plus many more innovations, and several large vendors offered COTS alternatives to the Internet which had commercial high reward prices in proportion to the high cost of the product development.

The panic set in among the low rewarded innovators who developed the Internet. They most objected to the high prices that high rewards for innovation required. They lobbied the “Atari Democrats” and others to have the restrictions on the Internet removed. The Clinton-Gore administration expedited that process, and that forced the high reward for innovation people like Bill Gates to order major changes in strategy. Gates had set out to beat Steve Case at AOL with MSN, but the embrace of the low reward Internet innovation forced both to go for low reward.

High reward is certainly something pursued on the Internet economy, but Google is not really one of them. Google refused to seek the high reward that Yahoo, Altavista, and a dozen others who were the innovators who paved the way for Google. Altavista was fast and clean search of a much larger database than Google until “everyone” called for high reward for innovation. Altavista was carved out of DEC, setup so employees could get stock options, and the stock listed to create high rewards for innovators, and that drove seeking ways to generate fast cash and profits leading to lots of ads which meant slower and cluttered search.

Bottom line: everyone knows and uses the Internet produced by low rewarded innovators. Basically no one knows about Altavista which was supposed to be as universal as the Internet thanks to high reward for innovation. Altavista should have beat Google because of all the tax breaks from capital gains on the high reward for innovation in the stock options in the 90s while the Google founders and employees were making low reward wages.

byomtovApril 5, 2014 at 11:05 pm

If we believe that investment has higher positive externalities over time than consumption, that militates in favor of leaving resources in the hands of wealthier individuals.

I don’t really buy this. It’s blind utilitarianism. There are various effects on the well-being of the less wealthy, the wealthy, and the beneficiaries of the positive externalities.

How do you propose to compare them?

Joe SmithApril 6, 2014 at 4:59 pm

We really need to look at the marginal externalities and not fall into the trap of looking at the average externality.

Leaving resources in the hands of wealthy individuals makes sense if it will increase the present value of future consumption by EVERYONE ELSE. There is little point in leaving resources in the hands of, say, Mitt Romney if the result will simply be that his great grand children will be able to enjoy a high level of consumption without working and no one else benefits.

Alexei SadeskiApril 6, 2014 at 7:18 am

This paper’s conclusion argues in favor of a 10,000,000% tax on politicians’ salaries and a 100,000,000,000,000,000,000,000,000,000% tax on Gawker, does it not?

Jacob OApril 7, 2014 at 9:01 am

There may be an excess of wage compression in academia, if you don’t count the postdocs and the adjuncts. Paying by marginal product would surely increase the salaries of some star research professors, but it would also mean paying postdocs at most institutions more than the $30-40 k they make today.